Lancaster University Management School Working Paper 2010 / 031 Hysteresis Effects under CIR Interest Rates

Most decision making research in real options focuses on revenue uncertainty assuming discount rates remain constant. However, for many decisions revenue or cost streams are relatively static and investment is driven by interest rate uncertainty, for example the decision to invest in durable machinery and equipment. Using interest rate models from Cox et al. (1985b), we generalize the work of Ingersoll and Ross (1992) in two ways. Firstly, we include real options on perpetuities (in addition to zero coupon cash flows). Secondly, we incorporate abandonment or disinvestment as well as investment options, and thus model interest rate hysteresis (parallel to revenue uncertainty in Dixit (1989a)). Under stochastic interest rates, economic hysteresis is found to be significant, even for small sunk costs.